4% Yielding Electric Utilities: A Cash Flow Analysis For The Income Investor

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Includes: D, DUK, ETR, OGE, PPL, SO
by: Bruce Miller

Summary

Regulated electric utilities are long-term reliable dividend paying stocks.

Utility dividends generally grow slowly but reliably.

Utilities are a staple of any true income portfolio.

Most of today's regulated electric utilities are still priced with current yields less than 4%. Per the Yahoo Industry Browser, I count over 300 electric utilities. Limiting this to those that are based in the U.S. and have yields of at least (or very close to) 4% cuts this to 13 with about 23 U.S. electric utilities yielding in the 2% to 4% range. Further refining this list to those that have paid a growing (but not necessarily growing each year) dividend for at least 10 years results in 6 utilities, with current yields ranging from 4.0% to 4.8% as of today's closing prices. These are (NYSE:D), (NYSE:PPL), (NYSE:OGE), (NYSE:DUK), (NYSE:SO) and (NYSE:ETR).

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The following is a bar chart to better see historical dividend growth rates:

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As can be seen, with few exceptions, dividends do grow slowly, with an unweighted average 10-year dividend Compound Annual Growth Rate (or CAGR) of 5% and one-year dividend CAGR of 5.4%. In an income portfolio like mine that includes the fixed income of preferred stock, I rely on higher growth stocks to provide the added dividend growth that when averaged with the zero dividend growth of preferred stock or very long maturity bonds, to provide a net portfolio income growth that will be at least sufficient to keep up with inflation. Unfortunately, regulated utility stocks are not income stocks that will provide very much of the required dividend growth, and so I typically hold them with my only requirement that they maintain their own inflation-offsetting income growth. Any additional dividend growth they provide is much appreciated, but I don't count on it.

The following are the Cash Flow Metrics I have used in past income stock analysis, which I will briefly describe:

1. Interest Coverage

As a fixed cost, the interest expense is perhaps one of the most important cash flow metrics for two reasons: if interest rates rise and the utility must refinance maturing debt, and heavily capitalized utilities can carry considerable debt or issue new debt, its cost of capital will increase. Second, if the economy slows and electricity demand slows and electricity bill delinquencies rise leading to declining revenues, it is difficult for management to manage away the fixed interest cost without having to sell assets into a depressed economy. Here I measure this interest rate sensitivity by determining the ratio of the interest expense to Cash Flow from Operations (or CFFO) + Interest Expense (I add interest back to CFFO as it was subtracted from revenue to arrive at CFFO) using a rolling 4 quarter period for both, over the past 10 quarters of data, which for these data will go through the 3Q2015.

I have found over the years that a ratio under 20% is a good balance and will generally be associated with acceptable and consistent dividend growth, while a ratio exceeding 30% is a cause for concern as it is simply starting to take too big a bite out of operational cash needed for paying the dividend and paying for required investing activities. Also note that this interest expense does not include interest that is capitalized into a construction project. Such capitalized interest is included in the Cash Flow From Investing Activies, or CFFI.

2. Dividend to CFFO Payout Ratio

Sustainably growing dividends are paid from operating cash, not from cash raised through the sale of assets, savings or generated from the sale of company debt and/or company stock. If preferred stock dividends are paid, I subtract them out of CFFO first to leave a preferred dividend adjusted CFFO that I then divide into the non-preferred dividends.

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Clearly, the lower the payout ratio, the greater the financial ability of the utility to use the remaining cash to put towards needed investing activities, particularly necessary Capital Expenditures (or CapEx). The more CapEx that can be paid with operational cash after dividends, the lower will be the cost of capital to the utility... generally. Here all utilities look good, with ETR and OGE the strongest of the group.

3. Percent of Investing Activities paid with (CFFO - Dividends)

As per #2 above, the more cash the company has after the dividend (CFFO - Dividend) to put towards Investing Activities, the lower will be the Cash Flow From Investing Activities (or CFFI) that will require the company sell debt or issue additional stock. A measure of this is to divide the CFFI by (CFFO - Dividend) and calculate this ratio, again using rolling 4 quarter totals to smooth out the spikes and troughs inherent with quarterly reporting.

An average of 80% of CFFI funded with operational cash after dividends is excellent for utilities, with OGE, DUK and ETR being able to fund all of the CFFI over several quarterly periods.

4. Return on Investing Activities to Operational Cash Flow

When a company makes investments, it is reasonable to expect to see both a rise in Revenues and from this, a rise in the bottom line of CFFO. By calculating the slope/quarter of the gradual rise (or fall) in CFFO over the past 10 quarters and dividing this by the average quarterly CFFI expenditure and then annualizing this (multiplying by 4) provides a past 10 quarter annual average of CFFO growth due to the investing activities.

This metric has a couple of limitations. It assumes the growth of CFFO is due to the CFFI made over the past 10 quarters and does not take into account investments made prior to this period. It is also an average over a 10Q period and does not consider trends. However, the growth of CFFO is critical to a sustainable and growing dividend and this is the best measure I've been able to derive in determining how well a company's managers are converting investment dollars into operational cash flows.

5. The "Managerial Efficiency Ratio"

This ratio simply divides the CFFO by the Revenue, using rolling 4 quarter totals. For each dollar of revenue that flows into the utility, how much of it will remain as net Operational Cash Flow?

This ratio will vary by industry, although it is comparable within a given industry. Generally, a larger percentage suggest management is efficient at managing expenses, overhead and other operational expenses within the company.

Recommendations:

A clear winner in this group would be OGE. It has shown strong dividend growth and is #1 or #2 in each of these metrics. OGE had a long history of a flat dividend from about 1992 to 2007... and that's a long dry spell. Clearly, management has put this utility on the right course.

DUK and D are reasonable choices in this group. Hitting in the middle of most measures with none that are alarming and some are quite favorable, such as their return on CFFI, DUK's improving ability to pay most of its CFFI from operational cash, very reasonable interest expense and D's strong dividend growth.

SO is another long-term consistent dividend paying utility. It has suffered from some recent cost over-runs and other small (relative to SO's revenues) misadventures that have hurt CFFO growth as can be seen on its return on CFFI, which has actually been negative over the past 10Q. SO has been increasing its CFFI thus requiring it to have to issue more in debt and company stock than it has in past years, totaling over $9B over the past 10Q, much higher than the next highest debt + equity issuance in the group ($6.6B from D). However, I hold SO and am confident management will put the company on a course to healthier cash flows in the quarters ahead, although I will be watching it.

ETR is an enigma. It has the best CFFI funding percent from (CFFO - Dividends) of the group, funding over 100% of its CFFI in 9 of the past 10 quarters. It has the lowest payout ratio of any utility I've ever seen and a low interest expense ratio. On revenues of about $11B/yr, over the past 10 quarters it has only raised a net of $876MM from debt and stock issuance, second only to OGE who has raised only $359MM. But dividend growth over the past 1, 3 and 5 years has been pathetic. I have no idea why, as the company certainly has the means to grow the dividend at least at the rate of inflation. Not sure if there are future events for which management wishes to build its savings (it currently has over $1B in cash) or if this is just a company run by a bunch of skin-flints. But I do know that it is not raising the dividend, and I don't think I'd buy this stock for its income with this kind of a dividend growth record and management lack of commitment to the dividend.

PPL is the other in the group I would not recommend. Its dividend did shoot up by 6.7% over the past year, but longer growth has been tepid. It's at the bottom of the heap in 4 of the above 5 metrics, with the greatest concern being its interest expense which, as previously mentioned, is hard to manage around if the economy and its electricity sales slow.

Conclusion

As I have said in previous articles, this CF analysis should only be part of your complete analysis of a company you are considering to add to your income portfolio. Future road-blocks or large potential threats need to be considered, although these tend to be more qualitative in their nature.

All of the data above I copy/pasted out of Morningstar. I have given it the "eye-ball" validity check, but I have not verified the values with those reported by the company on the 10Q and 10K shareholder reports. Also, I have done much, much math, and as can happen, some values may be in the wrong place or calculated incorrectly. I have triple checked my values with the raw data and did indeed find a couple of mistakes, so please do a quick verification check with the CF values at either Morningstar or one of the other web sites that provide financial report data, if you are considering adding one of these utilities to your income portfolio.

I hope you find this data useful in your ongoing quest for long-term reliable household income.

Disclosure: I am/we are long SO, DUK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.